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Sloshing

April 4, 2007 4:57 pmApril 4, 2007 4:57 pm

Left to their own devices, and couches, humans instinctively resist change. Kings and C.E.O.s like it at the top. Workers don’t volunteer to give up their jobs in the name of progress. Profits and productivity may create wealth, but how it gets into the right hands is another matter. Money doesn’t flow — that sounds so planned. It sloshes. There’s a difference. As scary as it sounds, it’s the chaos of markets that keeps us well fed and out of trouble.

You work, you get money. Congratulations. After covering bare essentials like food, shelter and a high-definition plasma TV, you save the rest. You can shove it in your mattress, but central bankers like our Federal Reserve, who haven’t the foggiest clue how much money is needed to run our economy, print more money every year. They target 2 percent inflation, which is another way of saying that they overprint dollars by 2 percent, diluting your worth. How rude. A 2-percent haircut by your very own government. Annoying, but it’s been going on forever. The Roman Emperors debased their coins from 4.5 grams of pure silver to less than a 10th of a gram over a few centuries. Stored wealth is an oxymoron.

Money wants to be invested, to generate returns. It not only wants to keep up with inflation so it doesn’t lose ground, it wants to help create wealth by funding the means of creating profits and then own a piece of those profits.

Liza Minelli insisted that money makes the world go around (along with that whole “life is a cabaret” nonsense), but it’s really the opposite: money goes around the world looking for profits — peeking in skyscrapers, factories, alleys, even gutters. Money sloshes around the globe seeking its highest returns, on a risk adjusted basis.

Money’s been sloshing around since creation (what’ll you give me for a rib?) in the form of gold and paper and now the online dollars and euros and yen of today that can make it from New York to Caracas in the blink of an eye.

You may not put your money to work, but someone else certainly will. Floors the size of football fields at brokerage firms and hedge funds are filled with traders and computer monitors blinking rapidly, sending money scurrying to the four corners looking for productive wealth-creating profits.

Chemicals in Copenhagen, a refinery in Russia and shoes in Shanghai all will attract capital if they can generate returns. No borders, no politics, no personalities; the only governor on funding is risk. Something may be rotten in Denmark, Putin may nationalize all energy companies, and maybe China’s baby teeth haven’t yet fallen out. Money may still slosh to these places, but it will fund only the very, very highest-return businesses. It’s why very little investment money ends up in Africa — the risks of poor infrastructure, undereducated workforces, corruption and a history of nationalization are so high that money just sloshes somewhere else. Lowering the risks is the only solution, or else money will stay away and not bother telling you why.

So here’s the dilemma for the United States. We all want money to stay local, to hire our workers and to invest in our own ideas and great companies. The trick is to have the best-looking prospects for profits along with the lowest risks. That’s what the stock market is for.

While money is a unit of work, a stock is nothing more than the sum of all future profits of a company (discounted back to the present for you persnickety sticklers). To raise money, you sell a share of those profits. You could convince your Uncle Ira to pony up some dough to help expand your ink company in Indiana or India. That counts as sloshing, sure. But how much of the company does he get, and how will he ever get his money back out? Not so obvious. Markets do this, for big enough companies anyway.

A stock exchange is nothing more than a busy room (or servers in Prague) that swaps shares around so that they end up in the right hands at the right price. The market values companies by valuing those future profits.

Markets put banks to shame — helping raise money in exchange for a share of the profits, rather than lending against some piece of collateral. Because it’s not only a company’s prospects that drives this action — the market changes its mind by the minute, worrying about economic growth, global stability, competition, technological change, politicians and every other worry you can imagine.

The stock market is the sum of what every investor in the world thinks. It doesn’t just listen to companies, it scours around for any information it can get to predict the future of profits — who is making them, how much, how good management is, and on and on. It’s daytime soap opera writ large. That’s why when Ben S. Bernanke, the Federal Reserve chairman, belches, markets erupt. The stock market allocates capital to companies that have what it believes are great prospects and starves those it no longer believes in.

There was once a great minicomputer company with Digital in its name. It was the leader in its field and had huge profit margins, was hiring people like crazy and in 1987 even hired the QE2 for a $20 million sales event in Boston. But over time, its stock kept going down. Wall Street analysts kept pounding the table, telling their clients to buy more shares. “The stock is cheap,” they repeated, “and profits are great.” The future was so bright they had to wear shades. There was no plausible explanation on why the stock was going down even though the outlook was so good.

What happened next was a decade-long decline, a drip, drip, drip of cutbacks and layoffs and plant closings and division sales as profits eroded. The C.E.O. was rightfully sacked. Minicomputers were slowly being displaced by workstations from Sun Microsystems and personal computers like Compaq’s, powered by Intel processors. In 1998, the once-pipsqueak PC maker Compaq used its highflying stock and cash to buy this company out, putting it out of its misery.

So it turned out the future wasn’t bright: The company was wearing blinders instead of shades. The stock market not only figured this out, but stopped the company from becoming an even bigger disaster. As money sloshed away and the stock declined, the market starved it of capital for growth, because better prospects were elsewhere.

No government bureaucrat had to raid that computer company’s offices and tell it to quit hiring and throwing lavish parties. The stock market did this. In Japan, where the stock market was rigged in the 1980s by cross ownership, and brokerage firms kept stock prices artificially high, operating losses at many Japanese companies were hidden under an accountant’s rug. The party went on and on until in 1991 it collapsed under its own weight, and Japan tread water through 15 years of turmoil and little growth.

We are lucky that Enron was not located in Tokyo, where it might have been deemed too big to fail. Good money might have been pumped in after bad to help Ken Lay-san stay afloat. Chrysler’s 1980 government bailout meant the stock market couldn’t do its job of starving a company that in retrospect should have been, as my veterinarian would say, put to sleep. GM and Ford would be in better shape today. Ditto airlines. Politics get in the way. What a shame.

O.K., enough of that. Want to find stocks that go up, that money will slosh towards? Me too! Here’s what works for me: Figure out what everyone else believes and then why they are wrong. Works every time. That should keep me and you busy for the rest of the month.

Excellent! Everything that is often missing in the press — honesty, insight, and humor. If I taught economics or finance this would be top list. But I don’t, so will send it out to friends and family! Also, very courageous — to write this in the nyts.
Cheers,
d

You write “a stock is nothing more than the sum of all future profits of a company (discounted back to the present for you persnickety sticklers).”

It’s not the profits, it’s the dividends. Is there any _rational_ reason to own a share of stock other than the expected _dividend_?

Why would anyone own a share of stock that pays no dividend except in the hope of selling it at a higher price, i.e. to find a “greater fool,” or in the hope that _someday_ it will pay a dividend?

I am not opposed to the notion of stocks. I understand their utility: they allow the accumulation of sufficient capital to enable production.

If I have a patent for a new and better mouse trap, and it will cost $100 (which I don’t have) to put in production, I can sell 100 shares of stock for $1 each. However, the only _rational_ reason I can see to buy the stock is in the expectation that sales of the new mouse trap will earn a profit _which will be distributed as dividends to the stockholders_.

It seems to me that if a corporation does not pay a dividend withing 1000 days of creation, it is a dog, and deserves to be “put to sleep.”

You’d own a company for the prospect of growth, and not necessarily dividends. If a company can’t figure out what to do with all the money they get, then it’s time to look elsewhere for the “next big thing”?

Andy:

What happens when the US Dollar is replaced by the Euro as the global currency and our trsy can no longer start printing an extra 2% a year? If anything at least all that extra money in our mattresses makes a nice cushion, and burns quite nicely for warmth. Heh, cheaper to burn dollar bills then pay for gas heating, that’ll be the day =)

Thank you, Gordon Gekko, for your powerful insights. My first impulse is to suggest that you read Garrett Hardin’s “The Tragedy of the Commons,” but on second thought, I think you should start with “Candide.” What is your slick advice to the rather large majority of the world’s population who aren’t “players” because they lacked the good sense to be born into patrician circumstances? You have a lot to learn, young man.

Hugh, a dividend is a distribution of profits (usually accumulated over time). Paying dividends is just one use of profits. Many times a company can find more productive uses for profits and the shareholders may want them to use the profits for other purposes, i.e. growing the business. This is especially true for less mature companies. Growth has its costs and must be funded somehow. So there are many rational reasons for companies not to pay dividends and for shareholders to not want the company to pay dividends. Look at it this way, if paying dividends increases the value of the firm by 1% but the same amount invested in another manner increases the value by 2%, the rational decision is to invest in another manner.

actually, if one could “Figure out what everyone else believes…,” then the smart thing to do would be to bet on that belief, not against it, at least in the short term, since it is their collective belief that moves the markets.

Dear Hugh,
Ah, those foolish Microsoft millionaires who never saw a dividend for 10 or more years. You get a dividend, you pay taxes. You invest the money in the company, your stock grows in value without taxes until you sell.

Brilliant. We need more of this, story-telling about the basics, and less academic arcana.

Hugh: profits are either retained or paid. Retained profit is a future dividend, waiting to happen. The point of the article can in theory be applied to the company: “keep the cash instead of pay it out, but only if you do better (get a better return) than us shareholders”

The value of a stock is determined not by profits and not, directly, by dividends. It’s determined by the rate of return at which cash flow can be invested — whether retained by the company for reinvestment or paid out in dividends for the shareholder to reinvest. Just another way of money sloshing around in search of the best return.

You state that market prices are determined by the sum of the expectations of all investors. Yet, in the last paragraph you make, the outlandish statement that one individual can consistently determine that billions of dollars are wrongly invested and trade accordingly.

Here’s my recommendation: if you think you could identify mispriced securities 51% of the time, then quit your day job. Otherwise, stop feeding the brokers. Specify your risk tolerance and invest accordingly in a broad array of indexed and bond funds. Use your spare time to play with your kids (or grandkids).

Enron is a case in point of how the stock market supports poorly managed non productive mega corportations who learn how to fool the stock market instead of producing actual profits. The perceptions created within the markets has a larger impact than the producers themselves in many cases. Take as example: a company in an early stage of development that is potentially groundbreaking and profitable but they don’t know how to play the market perception game like an Enron. The perception of the market may be that it is not go ing to achieve its potential and this reflection in the market causes it to starve.

Generally, an interesting layman’s description of capital markets, but I’m not sure you effectively advocate for the efficient market hypothesis, which seems to be the unstated thesis of your piece.

In addition, the logic in your examples are a little flawed … especially regarding DEC:

You say: “There was no plausible explanation on why the stock was going down even though the outlook was so good.” If that’s the case, then the markets were operating inefficiently – there must have been a plausible explanation or people wouldn’t have been selling. Also, you claim that a declining share price starves a company of capital – this really isn’t true, particularly in the days before options grants were a major component of employee compensation.

Hi Andy, Africans are not necessarily undereducated, if anything, they are miseducated because they have a system born from the British/Western ideal (an ideal that ill suits their future). Most programs related to technical education or the applications of real-world skills are cut to make room for western literature/English/math. It’s a scam and a shame. And I’m talking about when there is school available to people. Most times, money does ‘slosh’ into Africa as it’s attracted to oilbeds, diamond and gold veins and tourism — unfortunately, this money sits stagnant in the hands of corrupt leaders who were educated only in how to buy western luxuries at the expense of thousands of people and lost resources in the future. Some people don’t have the luxury of risk. PS: corruption started somewhere and most of the first leaders in Africa were educated in the West.

Not to pile on Hugh, but if all you care about is a steady dividend, why not buy a bond where you have collateral (excl the current tax advantages for dividends)? It seems like a lot of the NYT readers are pretty ignorant of what drives a stock price.

Owning a stock is all about growth in profit as that increased profit will increase value of the owners’ shares. The cumulative profit sets the baseline value for a stock, while growth prospects, which can be funded most cost effectively through retained earnings (i.e. not paying dividends), make up the second, more nebulous part of the stock’s price.

Just because the company is not paying out a profit does not mean it is going away. As the company reinvests its profits, it should drive increased earnings. This isn’t always the case – poor investments could lead to negative growth and lower stock value. But that’s part of the risk of owning a stock

Another excellent blog. Yesterday you explicitly invoked Adam Smith and his ‘invisible hand’ while today you do so implicitly. There are a few problems with this. First, Smith’s invisible hand assumed domestic investment because to invest across borders was then too risky. In a world-wide capital market, the world should be treated, then, like a nation, which for Smith meant providing education basic services and security for everyone. The European model works like this, but needs to be applied to the whole world. Second, Smith wrote before the industrial revolution and did not foresee the extent to which profits would be acheived through degrading and endangering the environment (externalizing production costs). If the market looks only at profits and companies are allowed to avoid the expenses of environmental protection, then following the market will lead us to environmental destruction. Proper laws are necessary to ensure against this. Finally, there is the problem of ‘class antagonisms’ through which capitalists are able to reap more than their share at the expense of the lower classes. This is due to concentrated resources and undue influence on government. It was a problem Smith saw and this is what he had to say about the capitalist class:

“The proposal of any new law or regulation of commerce which comes from this order ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.”

Congratulations. Your paper is a jewel of healthy common sense. It’s all there in a nutshell. I wish the French, bogged down as they are in the hazy remnants of the Marxist ideology, could grasp this message.
Michel

I found this interesting, but not “irreverent.” Kessler ends up justifying the problems of a global stock market that he at first seems to be lamenting.

The fleeting appearance of Africa seems sympathetic, but is indirectly dismissed later: “Politics get in the way. What a shame. … Here’s what works for me: Figure out what everyone else believes and then why they are wrong.”

I wonder if he means it is wrong to worry about starving Africans? And wrong of the LA Times to point out that the Bill & Melinda Gates Foundation “sloshes” their money around in Africa, hurting Africans being a part of their method of helping them?

Great article, but I have to say that current (neoclassical) economic theory overemphasizes the invisisble hand of Adam Smith and underempahsizes the idea of costly but unaccounted for externalities. To pollute the atmosphere with CO2 is almost entirely free, with a few exceptions, and the wealth that is created does not benefit the common good overall when you start to factor in rals costs–think the real cost of gasoline–which is twice as high as what we pay at the pump. Through war and environmental deterioration, as well as deaths from air pollution, we don’t do a good job of factoring in costs into our economic calculations.
Peru is a country with among the lowest levels of co2 emissions in the world, but it will be among the top 5 countries in the world in terms of costs in waterloss, food production loss, and species loss as its tropical glaciers continue to melt away.
You gave a great summary, which I enjoyed, but the missing piece is that markets can destroy the things on which we depend to surrive through the tragedy of the commons…as a previous reader pointed out…the opposite of what Adam Smith proclaimed.

Andy,
Great writing as always! I hope you write on one my pet peeves some day.
CEO and top executive salaries.
I was an engineer in 1970s in Silicon Valley. I hadn’t heard of any compay where the bosses made 100 to 1000 times the salary of their lowest paid employee. If my memory serves right the highest ratio was around 15 to 20. So what is with the $10-100 million compensation pacakages even for poorly performing bosses in these new economy? Something is obscene about this. It is probably immoral as well. Please write an article on this. Thanks.

Great article for humor and a general understanding of monetary economics and finance for those who have no clue. But it lacks depth and oversimplifies to reach conclusions that may be interpreted incorrectly by the masses.

“Markets put banks to shame — helping raise money in exchange for a share of the profits, rather than lending against some piece of collateral.”

Not quite sure what this means, but all things equal, wouldn’t you rather own an investment that has some kind of asset coverage?

Stocks represent the most subordinated, residual ownership in an enterprise. when a company is faced with bankruptcy these are the first-loss vehicles. On the other hand fixed income has provided a superior risk adjusted return over stocks during the past twenty years, and should be promoted more as an asset class. The size of debt markets trounce the stock market several times over, but for some reason the average joe doesn’t think about bonds when they watch CNBC talking heads cheerleading stocks all day long

It’s a strange thing and an interesting question, why would the average joe want to take more risk than he needs to?

I think Hugh in message 3 is on to something. Apart from dividends, how does the community of stock-holders benefit from owning shares in a company? Selling the stock merely moves assets around within the community of stock-holders, but doesn’t actually transfer any new wealth into that community.

Also, once a company has sold all of its shares, I also don’t see why it should care whether its stock price is high or low. Sure, low prices will annoy the stock-holders, but unless the company plans to sell more shares, why worry? The only reason I can see for why a company should care about its stock price is that it plans to sell more stock, i.e., it plans to dilute the wealth of its current owners.